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part
Financing the
Enterprise
W
I
L
S
O
N
,
6
J
A
M
CHAPTER 14 Accounting and Financial Statements
I
E the Financial System
CHAPTER 15 Money and
CHAPTER 16
Financial
5 Management and Securities Markets
0 Financial Planning
APPENDIX D Personal
5
1
B
U
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chapter
14
CHAPTER OUTLINE
Introduction
The Nature of Accounting
Accountants
Accounting or
Bookkeeping?
The Uses of Accounting
Information
Accounting
and Financial
W
I
Statements
L
S
O
N
,
The Accounting Process
The Accounting Equation
Double-Entry Bookkeeping
The Accounting Cycle
Financial Statements
The Income Statement
The Balance Sheet
The Statement of Cash
Flows
Ratio Analysis: Analyzing
Financial Statements
Profitability Ratios
Asset Utilization Ratios
Liquidity Ratios
Debt Utilization Ratios
Per Share Data
Industry Analysis
OBJECTIVES
J
After reading this chapter,
A you will be able to:
• Define accounting, andM
describe the different uses of accounting
information.
I
• Demonstrate the accounting process.
E
• Examine the various components of an income statement in order
to evaluate a firm’s “bottom line.”
5
• Interpret a company’s balance sheet to determine its current finan0
cial position.
5
• Analyze financial statements,
using ratio analysis, to evaluate a
company’s performance.
1
• Assess a company’s financial
position using its accounting stateB
ments and ratio analysis.
U
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W
I
L
S
The Richest Man in the World O
It is, after all, possible to be richer than Microsoft’sNBill Gates. For a brief time
,
in 2007, Fortune magazine listed the Mexican telecommunications
tycoon,
Carlos Slim Helú, at the top of the list. By 2008, Slim slipped back to number
two, with a fortune of $60 billion, while Warren Buffet
J took the number-one
spot with net worth of $62 billion. The son of Lebanese immigrants, Slim is a
A
self-made man. Dabbling in soft drinks, printing, and tobacco in the 1960s and
M by purchasing a num1970s, Slim managed to profit off the 1982 fiscal crisis
I the country’s economy
ber of companies for a fraction of their worth. When
E to realize considerable
bounced back at the end of the decade, Slim began
profits. For example, he purchased Mexico’s largest insurance company for
$44 million, and it is now worth around $2.5 billion.
5 However, Slim did not
make his first real fortune until 1990, when he bought the formerly national0
ized telephone company Teléfonos de México (Telmex).
5
Today, Slim owns more than 200 companies, and his wealth comprises
1
nearly 8 percent of Mexico’s entire GDP. Slim’s affluence
is growing at a fast
B 2005. In Mexico, Slim
pace; it has increased by more than $20 billion since
has been dubbed “Mr. Monopoly,” because of hisUstaggering wealth and the
market dominance of Telmex. Although Mexico has been privatizing industries since the 1990s, competition in the telephone industry has not increased.
Telmex still controls 92 percent of Mexico’s phone lines and 73 percent of cell
phones.
Slim’s critics complain that his stranglehold on the national phone service
has actually slowed development in the country. To date, only 20 percent of
Mexican residents have phone service, a number that remains low because
ENTER THE WORLD OF BUSINESS
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of the high price of service, according to the Organization for Cooperation and Economic Development. Many believe that Slim’s rates have kept
Mexican businesses from profiting and paying their workers as well as they
should. It has always been Slim’s modus operandi to purchase companies
when the price is low and then begin to force the competition out of the market. Mexico’s slow economic growth and lack of good jobs has fueled illegal
immigration into the United States, where jobs are perceived as plentiful and
the quality of life as higher. However, increasing illegal immigration has put a
financial strain on the U.S. government, while decreasing the supply of workers in Mexico—further slowing development.
Lack of competition not only halts development. It also decreases the
quality of services and accountability and encourages dishonest accounting
W
practices. Along with most of Latin America, Mexico has dealt with monopI
olies since Colonial times. In power for around 70 years, the political party
L
the Partido Revolucionario Institutional
(PRI) represented one of the longestS the Western hemisphere. The party faced little
lasting hegemonic powers in
or no opposition from 1929 to
Othe early 1990s. During this time, most monopolies were state owned and run.
N Finally, in the 1990s privatization movements,
coupled with the PRI’s loss of power, allowed private investors to step in and
,
buy out many state-owned companies. The monopolies did not end there,
however, with Slim being the preeminent example of a private monopolisJ Felipe Calderón, has taken a public stance
tic power. Mexico’s president,
ATelmex and has held talks with Slim over the
against such monopolies as
issue. However, large companies
M like Telmex tend to receive special treatment from the government,Igiven the huge amount of money and resources
they control. Slim himself claims that he welcomes competition and that his
E
actions, including his accounting practices, are transparent—but his behavior says otherwise.
5 that he runs monopolies, the Federal ComWhether or not Slim believes
0 plans to investigate Slim. In 1998 the FCC
munications Commission (FCC)
found Telmex guilty of colluding
5 with Sprint to overcharge for long distance
services. It is possible that1new findings could result in stiffer regulations
and calls for more transparent accounting practices. More rules might also
B
have a long-term impact on Slim’s wealth. As with many of the other richest
U
men in the world, much of Slim’s financial success depends on stock prices,
which depend on high performance. Increased oversight could call attention
to unethical accounting and other issues, which could cause prices to drop,
and his wealth would follow.1
424
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CHAPTER 14
Accounting and Financial Statements
425
Introduction
Accounting, the financial “language” that organizations use to record, measure, and
interpret all of their financial transactions and records, is very important in business.
All businesses—from a small family farm to a giant corporation—use the language
of accounting to make sure they use their money wisely and to plan for the future.
Nonbusiness organizations such as charities and governments also use accounting
to demonstrate to donors and taxpayers how well they are using their funds and
meeting their stated objectives.
This chapter explores the role of accounting in business and its importance in
making business decisions. First, we discuss the uses of accounting information and
the accounting process. Then, we briefly look at some simple financial statements
W
and accounting tools that are useful in analyzing organizations
worldwide.
I
L
Simply stated, accounting is the recording, measurement,
and interpretation of
S
financial information. Large numbers of people and institutions, both within and
outside businesses, use accounting tools to evaluateO
organizational operations. The
Financial Accounting Standards Board has been setting
N the principles standards of
financial accounting and reporting in the private sector since 1973. Its mission is to
, and reporting for the guidestablish and improve standards of financial accounting
The Nature of Accounting
accounting
the recording,
measurement, and
interpretation of
financial information
ance and education of the public, including issuers, auditors, and users of financial
information. However, the accounting scandals at the turn of the last century resulted
J
when many accounting firms and businesses failed to abide by generally accepted
accounting principles, or GAAP. More than 1,000 firms
A ultimately reported flaws in
their financial statements between 1997 and 2002; in 2002 alone, a record 330 comM
panies chose to restate their earnings to avoid further questions.2 Consequently, the
I rules, requirements, and polifederal government has taken a greater role in making
cies for accounting firms and businesses through theESecurities and Exchange Commission’s (SEC) Public Company Accounting Oversight Board. For example, Ernst &
Young, a leading accounting firm, was barred from undertaking new audit clients for
six months as penalty for abusing the agency’s auditor-independence
rules.3
5
To better understand the importance of accounting, we must first understand
who prepares accounting information and how it is 0
used.
5
1
B
U
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PART 6
Financing the Enterprise
Accountants
Many of the functions of accounting are carried out by public or private accountants.
Public Accountants. Individuals and businesses can hire a certified public
accountant (CPA), an individual who has been certified by the state in which
he or she practices to provide accounting services ranging from the preparation of
financial records and the filing of tax returns to complex audits of corporate financial records. Certification gives a public accountant the right to express, officially, an
unbiased opinion regarding the accuracy of the client’s financial statements. Most
public accountants are either self-employed or members of large public accounting firms such as Ernst & Young, KPMG, Deloitte & Touche, and PricewaterhouseCoopers, together referred to as “the Big Four.” In addition, many CPAs work for
one of the second-tier accounting
W firms that are much smaller than the Big Four
firms, as illustrated in Table 14.1. The accounting scandals at the turn of the cenItury, combined with more stringent accounting
Lrequirements legislated by the Sarbanes-Oxley
have increased job prospects for accountants
SAct,
and students with accounting degrees as comO
panies and accounting firms hire more auditors
to satisfy the law and public demand for greater
N
transparency.4
, With the demise of Arthur Andersen there have
been concerns about one of the remaining Big Four
accounting firms failing. The U.S. Chamber of ComJmerce published a report calling for regulators and
policy makers to keep such an event from happenA
ing again to maintain competition and availability
M
of accountants.5
The insurance and financial services provider AIG is among the many
U.S. firms hiring more forensic accountants. Forensic accountants
I A growing area for public accountants is forensic
utilize their accounting, auditing, and investigative skills to check the
accounting, which is accounting that is fit for legal
Ereview. It involves analyzing financial documents
books of companies.
in search of fraudulent entries or financial misconduct. Functioning as much like
detectives as accountants, forensic accountants have been used since the 1930s. In the
5 of the accounting scandals of the early 2000s,
wake
many
0 auditing firms are rapidly adding or expandDid You Know? Corporate fraud costs are
ing
5 forensic or fraud-detection services. Additionestimated at $600 billion annually.6
ally, many forensic accountants root out evidence of
1
“cooked
books” for federal agencies like the Federal
Bureau of Investigation or the B
Internal Revenue Service. The Association of Certified Fraud Examiners, which certifies accounting professionals as certified fraud
examiners (CFEs), has grown toU
more than 45,000 members.7
certified public
accountant (CPA)
an individual who has
been state certified to
provide accounting
services ranging from
the preparation of
financial records and
the filing of tax returns
to complex audits of
corporate financial
records
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CHAPTER 14
Accounting and Financial Statements
2007 Revenues
($ Millions)
2008 VAULT Accounting
Firm Prestige Rankings
PricewaterhouseCoopers
$25,150
7.616
Company
“Big Four”
Ernst & Young
21,100
7.415
Deloitte & Touche
9,800
7.035
KPMG
19,800
6.447
Grant Thornton
1,075
6.009
BDO Seidman
589
5.720
427
TABLE 14.1
Leading Accounting
Firms
Second-Tier Firms
W
5.708
I
Source: “Accounting Firm Rankings,” “Vault Top 40 Accounting Firms,” www.vault.com/nr/finance_rankings/
accounting_rankings.jsp?accounting2008⫽2 (accessed May 20, 2008).
L
S
O
Private Accountants. Large corporations, government agencies, and other organizations may employ their own private accountants
N to prepare and analyze their
financial statements. With titles such as controller, tax accountant, or internal audi,
tor, private accountants are deeply involved in many of the most important financial
McGladrey & Pullen
1,300
decisions of the organizations for which they work. Private accountants can be CPAs
and may become certified management accountants
(CMAs) by passing a
J
rigorous examination by the Institute of Management Accountants.
A
M
The terms accounting and bookkeeping are often mistakenly used interchangeably.
I
Much narrower and far more mechanical than accounting,
bookkeeping is typically
limited to the routine, day-to-day recording of business
transactions.
BookkeepE
Accounting or Bookkeeping?
ers are responsible for obtaining and recording the information that accountants
require to analyze a firm’s financial position. They generally require less training
than accountants. Accountants, on the other hand,5usually complete course work
beyond their basic four- or five-year college accounting degrees. This additional
0 information, but to undertraining allows accountants not only to record financial
stand, interpret, and even develop the sophisticated accounting
systems necessary to
5
classify and analyze complex financial information.
private accountants
accountants employed
by large corporations,
government agencies,
and other organizations
to prepare and analyze
their financial
statements
certified management
accountants (CMAs)
private accountants
who, after rigorous
examination, are
certified by the
National Association of
Accountants and who
have some managerial
responsibility
1
B
The Uses of Accounting Information
Accountants summarize the information from a firm’s
U business transactions in various financial statements (which we’ll look at in a later section of this chapter) for
a variety of stakeholders, including managers, investors, creditors, and government
agencies. Many business failures may be directly linked to ignorance of the information “hidden” inside these financial statements. Likewise, most business successes
can be traced to informed managers who understand the consequences of their
decisions. While maintaining and even increasing short-run profits is desirable, the
failure to plan sufficiently for the future can easily lead an otherwise successful company to insolvency and bankruptcy court.
Basically, managers and owners use financial statements (1) to aid in internal
planning and control and (2) for external purposes such as reporting to the Internal
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428
PART 6
Financing the Enterprise
Revenue Service, stockholders, creditors, customers, employees, and other interested
parties. Figure 14.1 shows some of the users of the accounting information generated by a typical corporation.
managerial accounting
the internal use of
accounting statements
by managers in planning
and directing the
organization’s activities
cash flow
the movement of money
through an organization
over a daily, weekly,
monthly, or yearly basis
budget
an internal financial
plan that forecasts
expenses and income
over a set period of
time
Internal Uses. Managerial accounting refers to the internal use of accounting statements by managers in planning and directing the organization’s activities. Perhaps management’s greatest single concern is cash flow, the movement
of money through an organization over a daily, weekly, monthly, or yearly basis.
Obviously, for any business to succeed, it needs to generate enough cash to pay its
bills as they fall due. However, it is not at all unusual for highly successful and rapidly growing companies to struggle to make payments to employees, suppliers, and
lenders because of an inadequate cash flow. One common reason for a so-called
“cash crunch,” or shortfall, is poor
Wmanagerial planning.
Managerial accountants also help prepare an organization’s budget, an internal financial plan that forecastsI expenses and income over a set period of time. It
is not unusual for an organization
L to prepare separate daily, weekly, monthly, and
yearly budgets. Think of a budget as a financial map, showing how the company
expects to move from Point A toSPoint B over a specific period of time. While most
companies prepare master budgets
O for the entire firm, many also prepare budgets
for smaller segments of the organization such as divisions, departments, product
N budgets begin at the upper management level
lines, or projects. “Top-down” master
and filter down to the individual, department level, while “bottom-up” budgets start
at the department or project level and are combined at the chief executive’s office.
Generally, the larger and more rapidly growing an organization, the greater will be
the likelihood that it will build its
J master budget from the ground up.
Regardless of focus, the principal value of a budget lies in its breakdown of cash
A
inflows and outflows. Expected operating expenses (cash outflows such as wages,
M
materials costs, and taxes) and operating
revenues (cash inflows in the form of payments from customers) over a Iset period of time are carefully forecast and subsequently compared with actual results. Deviations between the two serve as a “trip
E
FIGURE 14.1
The Users of Accounting
Information
Source: Belverd E. Needles,
Henry R. Anderson, and
James C. Caldwell, Principles
of Accounting, 4th edition.
Copyright © 1990 by Houghton
Mifflin Company. Reprinted with
permission.
Management
Owners, partners
Boards of
directors
Officers of the
company
Managers
Department heads
Supervisors
5
0
5
1
Those with Direct B
Financial Interest
Present or
U
potential
investors
Present or
potential creditors
Business Activities
Accounting
Tax
Authorities
Federal
(IRS)
State
Municipal
Other
Those with Indirect Financial Interest
Economic
Regulatory
Other
Planners
Agencies
Groups
SEC
Stock
exchanges
ICC, FAA,
etc.
Other
agencies
Council of
Economic
Advisors
Federal
Reserve Board
Government
planners
Employees
and labor
unions
Financial
advisors
Customers
and the
general public
Actions That Affect Business Activities
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CHAPTER 14
Accounting and Financial Statements
429
wire” or “feedback loop” to launch more detailed financial analyses in an effort to
pinpoint trouble spots and opportunities.
External Uses. Managers also use accounting statements to report the business’s
financial performance to outsiders. Such statements are used for filing income taxes,
obtaining credit from lenders, and reporting results to the firm’s stockholders. They
become the basis for the information provided in the official corporate annual
report, a summary of the firm’s financial information, products, and growth plans
for owners and potential investors. While frequently presented between slick, glossy
covers prepared by major advertising firms, the single most important component
of an annual report is the signature of a certified public accountant attesting that
the required financial statements are an accurate reflection of the underlying financial condition of the firm. Financial statements meeting
W these conditions are termed
audited. The primary external users of audited accounting information are governI and lenders, suppliers, and
ment agencies, stockholders and potential investors,
employees.
L
Federal, state, and local governments (both domestic and overseas) require orgaS
nizations to file audited financial statements concerning taxes owed and paid, payroll deductions for employees, and, for corporations,O
new issues of securities (stocks
and bonds). Even nonprofit corporations and other nonbusiness organizations
N
may be required to file regular financial statements. While corporations make the
,
news most frequently for financial scandals, even governments
are not immune to
accounting problems. Germany’s free-market party, the Freie Demokratische Partei
or FDP, has been accused of falsely accounting for more than €1.66 million, or $2.5
million, in party donations between 1996 and 2000.JUnder the leadership of nowdeceased Juergen Moelleman, the party was guilty ofAserious ethical and accounting
infractions—including hiding large donations by recording them as small donaM to remedy the situation and
tions under false names. The federal treasury is seeking
is fining the party €5 million. Because of the wronglyI accounted for donations, all of
the party’s financial statements are also being called into question by parliamentary
E million.8 Like individuals,
auditors, which could cost the FDP an additional €7.24
well-managed companies generally try to minimize their taxable income by using
accepted accounting practices. Usually, accounting practices that reduce taxes also
reduce reported profits. By reducing taxes, the firm5increases the cash available to
the firm that can be used for many purposes, such 0
as plant expansion, debt retirement, or repurchase of common stock.
5
A corporation’s stockholders use financial statements to evaluate the return
on their investment and the overall quality of the 1
firm’s management team. As a
result, poor performance, as documented in the financial
B statements, often results
in changes in top management. Potential investors study the financial statements in
U
a firm’s annual report to determine whether the company
meets their investment
requirements and whether the returns from a given firm are likely to compare favorably with other similar companies.
Banks and other lenders look at financial statements to determine a company’s
ability to meet current and future debt obligations if a loan or credit is granted. To
determine this ability, a short-term lender examines a firm’s cash flow to assess its
ability to repay a loan quickly with cash generated from sales. A long-term lender is
more interested in the company’s profitability and indebtedness to other lenders.
Labor unions and employees use financial statements to establish reasonable
expectations for salary and other benefit requests. Just as firms experiencing record
profits are likely to face added pressure to increase employee wages, so too are
fer11722_ch14_421-457.indd 429
annual report
summary of a firm’s
financial information,
products, and growth
plans for owners and
potential investors
9/22/08 2:19:18 PM
Confirming Pages
Going Green
Hertz Goes Green: Generating Cost versus Benefit Decisions
As gas prices and concern for the environment grow, the
demand for hybrids and fuel-efficient cars is also on the rise.
Among those answering the call is the rental car company
Hertz. In 2006, Hertz launched its Green Collection, which
originally included four makes: Toyota Camry, Ford Fusion,
Buick LaCrosse, and Hyundai Sonata. All of these cars have
a fuel efficiency of 28 mpg or more, earning them a high EPA
SmartWay rating. The EPA SmartWay rating system examines
air pollution and greenhouse gas emissions. Cars are ranked
on a scale of 0 to 10 for each criterion, with 10 being the highest and 5 being average. All Hertz Green Collection cars must
score at least a 6 on both. In 2007, Hertz added the Toyota
Prius to its line of Green cars. With SmartWay Elite ratings
of 9.5 for air pollution and 10 for greenhouse gas emissions,
the Prius holds the highest ranking in the Hertz fleet and possesses one of the highest ratings on the market today.
For consumers seeking to be eco-friendly even when
away from their normal car, the Green Collection from Hertz is
helping make it easier for car renters to make environmentally
responsible decisions. While, Hertz’s eco-friendly line is still a
tiny part of its overall fleet, with offerings at only around 50 airports nationwide, the company is working to expand this number. During 2007, Hertz purchased nearly 4,500 Priuses, a move
that cost the company more than $65 million. The company is
also working to expand the availability of ethanol-fueled cars
throughout the Midwest, where corn ethanol is plentiful.
The Green Collection costs around $5 to $10 per day more
than renting a regular car, which means those not interested
in environmental issues are not likely to rent from the Green
collection. Business travelers might also be forbidden from
renting more expensive cars by their company’s accounting policies. Hertz claims that most drivers will make up the
cost differential in fuel savings, although this depends on
the model and how much driving a renter does. Even if this is
true, for business travelers who must watch their costs, new
accounting policies may need to be put in place that specify
what kinds of cars employees can rent and whether they
include more expensive but more fuel-efficient models. Some
analysts who support this “green” movement in the rental car
industry have also expressed concern that consumers will
balk at paying an additional fee to drive a more efficient car.
WNo one is arguing, however, that moving toward a more fuelefficient
fleet is a smart step for Hertz. The company recently
I
stated that by adding 1,000 hybrids to its fleet, it will reduce
L dioxide emissions by about 3,000 tons annually. In addicarbon
tion,
S Hertz now donates $1 to the National Park Foundation for
each Green Collection car rental. If you believe that every little
O counts, then an extra $5 to $10 a day for a Prius or Camry
step
9
the
Nnext time you need to rent a car is a small price to pay.
,
Discussion
Questions
1. Aside from helping the environment, what are some of the
advantages of Hertz adding a Green Collection to its fleet?
2.JThe up-front cost of acquiring thousands of eco-friendly
cars is very high for Hertz. What is Hertz anticipating
Aabout consumer tastes and demands that would allow it
Mto justify such a large expense?
3. How could positioning itself as the eco-friendly rental
I company that has low-emissions cars and donates to
environmental causes help Hertz’s bottom line?
E
5
employees unlikely to grant employers
wage and benefit concessions without considerable evidence of financial distress.
0
5
The Accounting Process
1
Many view accounting as a primary business language. It is of little use, however,
B it. Fortunately, the fundamentals—the accountunless you know how to “speak”
ing equation and the double-entry
U bookkeeping system—are not difficult to learn.
These two concepts serve as the starting point for all currently accepted accounting
principles.
assets
a firm’s economic
resources, or items of
value that it owns, such
as cash, inventory, land,
equipment, buildings,
and other tangible and
intangible things
The Accounting Equation
Accountants are concerned with reporting an organization’s assets, liabilities, and
owners’ equity. To help illustrate these concepts, consider a hypothetical floral shop
called Anna’s Flowers, owned by Anna Rodriguez. A firm’s economic resources, or
items of value that it owns, represent its assets—cash, inventory, land, equipment,
buildings, and other tangible and intangible things. The assets of Anna’s Flowers include counters, refrigerated display cases, flowers, decorations, vases, cards,
430
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CHAPTER 14
Accounting and Financial Statements
and other gifts, as well as something known as “goodwill,” which in this case is Anna’s
reputation for preparing and delivering beautiful floral arrangements on a timely
basis. Liabilities, on the other hand, are debts the firm owes to others. Among
the liabilities of Anna’s Flowers are a loan from the Small Business Administration
and money owed to flower suppliers and other creditors for items purchased. The
owners’ equity category contains all of the money that has ever been contributed
to the company that never has to be paid back. The funds can come from investors
who have given money or assets to the company, or it can come from past profitable operations. In the case of Anna’s Flowers, if Anna were to sell off, or liquidate,
her business, any money left over after selling all the shop’s assets and paying off
its liabilities would comprise her owner’s equity. The relationship between assets,
liabilities, and owners’ equity is a fundamental concept in accounting and is known
W
as the accounting equation:
I equity
Assets ⫽ Liabilities ⫹ Owner’s
L
S
Double-entry bookkeeping is a system of recording
and classifying business
transactions in separate accounts in order to maintain
the
balance
of the accounting
O
equation. Returning to Anna’s Flowers, suppose Anna buys $325 worth of roses on
N order. When she records this
credit from the Antique Rose Emporium to fill a wedding
transaction, she will list the $325 as a liability or a debt, to a supplier. At the same time,
431
liabilities
debts that a firm owes
to others
owners’ equity
equals assets minus
liabilities and reflects
historical values
accounting equation
assets equal liabilities
plus owners’ equity
Double-Entry Bookkeeping
however, she will also record $325 worth of roses as an asset in an account known as
“inventory.” Because the assets and liabilities are on different sides of the accounting
equation, Anna’s accounts increase in total size (by $325)
J but remain in balance:
double-entry bookkeeping
a system of recording
and classifying
business transactions
that maintains the
balance of the
accounting equation
Assets ⫽ Liabilities ⫹ Owner’s
Aequity
$325 ⫽ $325
M
Thus, to keep the accounting equation in balance, each
I business transaction must
be recorded in two separate accounts.
E
In the final analysis, all business transactions are classified
as either assets, liabilities, or owners’ equity. However, most organizations further break down these three
accounts to provide more specific information about a transaction. For example,
5 as cash, inventory, and equipassets may be broken down into specific categories such
ment, while liabilities may include bank loans, supplier
0 credit, and other debts.
Figure 14.2 shows how Anna used the double-entry bookkeeping system to
account for all of the transactions that took place 5
in her first month of business.
These transactions include her initial investment of 1
$2,500, the loan from the Small
Business Administration, purchases of equipment and inventory, and the purchase
B generated revenues of $2,000
of roses on credit. In her first month of business, Anna
by selling $1,500 worth of inventory. Thus, she deducts,
U or (in accounting notation
that is appropriate for assets) credits, $1,500 from inventory and adds, or debits,
$2,000 to the cash account. The difference between Anna’s $2,000 cash inflow and
her $1,500 outflow is represented by a credit to owners’ equity, because it is money
that belongs to her as the owner of the flower shop.
The Accounting Cycle
In any accounting system, financial data typically pass through a four-step procedure sometimes called the accounting cycle. The steps include examining source
documents, recording transactions in an accounting journal, posting recorded
transactions, and preparing financial statements. Figure 14.3 shows how Anna works
fer11722_ch14_421-457.indd 431
accounting cycle
the four-step procedure
of an accounting
system: examining
source documents,
recording transactions
in an accounting
journal, posting
recorded transactions,
and preparing financial
statements
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PART 6
Financing the Enterprise
FIGURE 14.2 The Accounting Equation and Double-Entry Bookkeeping for Anna’s Flowers
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S
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N
,
J
through them. Traditionally, all of these steps were performed using paper, pencils,
and erasers (lots of erasers!), butAtoday the process is often fully computerized.
M
Step One: Examine Source Documents. Like all good managers, Anna Rodriguez begins the accounting cycleI by gathering and examining source documents—
checks, credit-card receipts, sales slips, and other related evidence concerning specific
E
transactions.
journal
a time-ordered list of
account transactions
ledger
a book or computer file
with separate sections
for each account
Step Two: Record Transactions. Next, Anna records each financial transac5 just a time-ordered list of account transactions.
tion in a journal, which is basically
While most businesses keep a general
0 journal in which all transactions are recorded,
some classify transactions into specialized journals for specific types of transaction
5
accounts.
1 Anna next transfers the information from her
Step Three: Post Transactions.
journal into a ledger, a book B
or computer program with separate files for each
account. This process is known as posting. At the end of the accounting period (usuU or monthly), Anna prepares a trial balance, a
ally yearly, but occasionally quarterly
summary of the balances of all the accounts in the general ledger. If, upon totalling,
the trial balance doesn’t (that is, the accounting equation is not in balance), Anna
or her accountant must look for mistakes (typically an error in one or more of the
ledger entries) and correct them. If the trial balance is correct, the accountant can
then begin to prepare the financial statements.
Step Four: Prepare Financial Statements. The information from the trial
balance is also used to prepare the company’s financial statements. In the case
of public corporations and certain other organizations, a CPA must attest, or
certify, that the organization followed generally accepted accounting principles
fer11722_ch14_421-457.indd 432
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CHAPTER 14
Accounting and Financial Statements
433
FIGURE 14.3 The Accounting Process for Anna’s Flowers
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S
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N
,
J
A
M
I
E
5
0
5
1
B
U
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PART 6
Financing the Enterprise
in preparing the financial statements. When these
statements have been completed, the organization’s
books are “closed,” and the accounting cycle begins
anew for the next accounting period.
Financial Statements
The end result of the accounting process is a series of
financial statements. The income statement, the balance sheet, and the statement of cash flows are the
best-known examples of financial statements. They
are provided to stockholders and potential investors
Wa firm’s annual report as well as to other relevant
in
outsiders
such as creditors, government agencies,
I
and the Internal Revenue Service.
L It is important to recognize that not all financial
statements
follow precisely the same format. The fact
S
that different organizations generate income in difO ways suggests that when it comes to financial
ferent
statements,
one size definitely does not fit all. ManuN
facturing firms, service providers, and nonprofit
,
organizations
each use a different set of accounting
principles or rules upon which the public accounting profession has agreed. As we have already menJ
tioned,
these are sometimes referred to as generally
accepted
accounting principles (GAAP). Each country
A
has a different set of rules that the businesses within
M
Grant Thorton LLP provides comprehensive accounting services such
that country are required to use for their accounting
as auditing of financial statements to its clients.
process
and financial statements. Moreover, as is the
I
case in many other disciplines, certain concepts have
E
more than one name. For example, sales and revenues are often interchanged, as are
profits, income, and earnings. Table 14.2 lists a few common equivalent terms that
should help you decipher their meaning
in accounting statements.
5
TABLE 14.2
Term
Equivalent Terms in
Accounting
Revenues
Gross profit
0
5
1
B
U
Operating income
Income before taxes (IBT)
Net income (NI)
Income available to common stockholders
fer11722_ch14_421-457.indd 434
Equivalent Term
Sales
Goods or services sold
Gross income
Gross earnings
Operating profit
Earnings before interest and taxes (EBIT)
Income before interest and taxes (IBIT)
Earnings before taxes (EBT)
Profit before taxes (PBT)
Earnings after taxes (EAT)
Profit after taxes (PAT)
Earnings available to common stockholders
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CHAPTER 14
Accounting and Financial Statements
435
The Income Statement
The question, “What’s the bottom line?” derives from the income statement, where
the bottom line shows the overall profit or loss of the company after taxes. Thus, the
income statement is a financial report that shows an organization’s profitability over a period of time, be that a month, quarter, or year. By its very design, the
income statement offers one of the clearest possible pictures of the company’s overall
revenues and the costs incurred in generating those revenues. Other names for the
income statement include profit and loss (P&L) statement or operating statement. A
sample income statement with line-by-line explanations is presented in Table 14.3,
income statement
a fianancial report that
shows an organization’s
profitability over a
period of time—month,
quarter, or year
W
The following exhibit presents a sample income statementI with all the terms defined and explained.
Company Name for the Year Ended December 31
L
Revenues (sales)
Total dollar amount of
Sproducts sold (includes income from other business services
such as rental-lease income and interest income).
Othe goods and services, including the cost of labor and raw
Less: Cost of goods sold
The cost of producing
materials as well as other expenses associated with production.
N
Gross profit
The income available after paying all expenses of production.
,
Less: Selling and administrative The cost of promoting, advertising, and selling products as well as the overhead
TABLE 14.3
Sample Income Statement
expense
Income before interest and taxes
(operating income or EBIT)
Less: Interest expense
Income before taxes
(earnings before taxes—EBT)
Less: Taxes
Net income
Less: Preferred dividends
costs of managing the company. This includes the cost of management and
corporate staff. One non-cash expense included in this category is depreciation,
which approximatesJ
the decline in the value of plant and equipment assets due to
use over time. In most accounting statements, depreciation is not separated from
A expenses. However, financial analysts usually create
selling and administrative
statements that include
M this expense.
This line represents all income left over after operating expenses have been
I
deducted. This is sometimes
referred to as operating income since it represents all
income after the expenses of operations have been accounted for. Occasionally,
E
this is referred to as EBIT, or earnings before interest and taxes.
Interest expense arises as a cost of borrowing money. This is a financial expense
rather than an operating expense and is listed separately. As the amount of debt
5
and the cost of debt increase, so will the interest expense. This covers the cost of
both short-term and 0
long-term borrowing.
The firm will pay a tax on this amount. This is what is left of revenues after
5 costs, depreciation costs, and interest costs.
subtracting all operating
1 in the federal tax code.
The tax rate is specified
This is the amount ofB
income left after taxes. The firm may decide to retain all or a
portion of the income for reinvestment in new assets. Whatever it decides not to
keep it will usually pay
Uout in dividends to its stockholders.
If the company has preferred stockholders, they are first in line for dividends. That is
one reason why their stock is called “preferred.”
Income to common stockholders
This is the income left for the common stockholders. If the company has a good
year, there may be a lot of income available for dividends. If the company has a bad
year, income could be negative. The common stockholders are the ultimate owners
and risk takers. They have the potential for very high or very poor returns since they
get whatever is left after all other expenses.
Earnings per share
Earnings per share is found by taking the income available to the common
stockholders and dividing by the number of shares of common stock outstanding.
This is income generated by the company for each share of common stock.
fer11722_ch14_421-457.indd 435
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436
PART 6
revenue
the total amount of
money received from the
sale of goods or services,
as well as from related
business activities
while Table 14.4 presents the income statement of Starbucks. The income statement
indicates the firm’s profitability or income (the bottom line), which is derived by
subtracting the firm’s expenses from its revenues.
cost of goods sold
the amount of money
a firm spent to buy or
produce the products it
sold during the period
to which the income
statement applies
TABLE 14.4
Consolidated Statements
of Earnings for Starbucks
(in thousands, except
earnings per share)
Financing the Enterprise
Revenue. Revenue is the total amount of money received (or promised) from
the sale of goods or services, as well as from other business activities such as the
rental of property and investments. Nonbusiness entities typically obtain revenues
through donations from individuals and/or grants from governments and private
foundations. Starbucks’ income statement (see Table 14.4) shows one main source
of income: sales of Starbucks’ products.
For most manufacturing and retail concerns, the next major item included in
the income statement is the cost of goods sold, the amount of money the firm
Fiscal Year Ended
Net revenues:
Company-operated retail
Specialty:
Licensing
Foodservice and other
Total specialty
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,
Sept 30, 2007
Oct 1, 2006
Oct 2, 2005
$7,998,265
$6,583,098
$5,391,927
1,026,338
860,676
673,015
386,894
343,168
304,358
1,413,232
1,203,844
977,373
Total net revenues
9,411,497
7,786,942
6,369,300
J
Cost of sales including occupancy costs
3,999,124
3,178,791
2,605,212
3,215,889
2,687,815
2,165,911
294,136
253,724
192,525
467,160
387,211
340,169
A
Other operating expenses
M
Depreciation and amortization expenses
I
General and administrative expenses
Total operating expenses E
Store operating expenses
489,249
479,386
361,613
8,465,558
6,986,927
5,665,430
Income from equity investees
Operating income
Net interest and other income
Earnings before income taxes
Income taxes
Earnings before cumulative effect
of change in accounting principle
Cumulative effect of accounting
change for FIN 47, net of taxes
93,937
76,648
893,952
780,518
5
0
5
1
B
U
108,006
1,053,945
2,419
12,291
15,829
1,056,364
906,243
796,347
383,726
324,770
301,977
672,638
581,473
494,370
—
17,214
—
$ 672,638
$ 564,259
$ 494,370
Net earnings—basic
$
0.90
$
0.74
$
0.63
Net earnings—diluted
$
0.87
$
0.71
$
0.61
Net earnings
Per common share:
Weighted average shares outstanding:
Basic
749,763
766,114
789,570
Diluted
770,091
792,556
815,417
Source: media.corporate-ir.net/media_files/irol/99/99518/2007AR (accessed September 18, 2008).
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CHAPTER 14
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437
spent (or promised to spend) to buy and/or produce the products it sold during the
accounting period. This figure may be calculated as follows:
Cost of goods sold ⫽ Beginning inventory ⫹ Interim purchases ⫺ Ending inventory
Let’s say that Anna’s Flowers began an accounting period with an inventory of
goods for which it paid $5,000. During the period, Anna bought another $4,000
worth of goods, giving the shop a total inventory available for sale of $9,000. If, at
the end of the accounting period, Anna’s inventory was worth $5,500, the cost of
goods sold during the period would have been $3,500 ($5,000 ⫹ $4,000 ⫺ $5,500
⫽ $3,500). If Anna had total revenues of $10,000 over the same period of time, subtracting the cost of goods sold ($3,500) from the total revenues of $10,000 yields the
store’s gross income or profit (revenues minus the cost of goods sold required
Wof goods sold was just under
to generate the revenues): $6,500. For Starbucks, cost
$4 billion in 2007. Notice that Starbucks calls it cost
I of sales, rather than cost of
goods sold. This is because Starbucks buys raw materials and supplies and produces
L
drinks.
S day-to-day operations of an
Expenses. Expenses are the costs incurred in the
organization. Three common expense accounts shown
O on income statements are
(1) selling, general, and administrative expenses; (2) research, development, and engiN
neering expenses; and (3) interest expenses (remember that the costs directly attributable to selling goods or services are included in the cost, of goods sold). Selling expenses
include advertising and sales salaries. General and administrative expenses include salaries of executives and their staff and the costs of owning and maintaining the general
J engineering, and marketing
office. Research and development costs include scientific,
personnel and the equipment and information usedA
to design and build prototypes
and samples. Interest expenses include the direct costs of borrowing money.
The number and type of expense accounts varyMfrom organization to organization. Included in the general and administrativeI category is a special type of
expense known as depreciation, the process of spreading the costs of long-lived
assets such as buildings and equipment over the totalEnumber of accounting periods
in which they are expected to be used. Consider a manufacturer that purchases a
$100,000 machine expected to last about 10 years. Rather than showing an expense
of $100,000 in the first year and no expense for that5equipment over the next nine
years, the manufacturer is allowed to report depre- 0
ciation expenses of $10,000 per year in each of the
next 10 years because that better matches the cost of 5
the machine to the years the machine is used. Each 1
time this depreciation is “written off ” as an expense,
B
the book value of the machine is also reduced by
$10,000. The fact that the equipment has a zero U
value on the firm’s balance sheet when it is fully
depreciated (in this case, after 10 years) does not
necessarily mean that it can no longer be used or is
economically worthless. Indeed, in some industries,
machines used every day have been reported as having no book value whatsoever for over 30 years.
Net Income. Net income (or net earnings) is
the total profit (or loss) after all expenses including
taxes have been deducted from revenue. Generally,
fer11722_ch14_421-457.indd 437
gross income (or profit)
revenues minus the
cost of goods sold
required to generate
the revenues
expenses
the costs incurred
in the day-to-day
operations of an
organization
depreciation
the process of
spreading the costs of
long-lived assets such
as buildings and
equipment over
the total number of
accounting periods in
which they are
expected to be used
net income
the total profit (or loss)
after all expenses,
including taxes, have
been deducted from
revenue; also called net
earnings
Firms and corporations like this lumber mill shown here depreciate,
or spread out the cost, of their many assets over a certain number of
accounting periods.
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Rev. Confirming Pages
Entrepreneurship in Action
Pursuing a Life-Long Dream, a Social Worker and Teacher
Gets an A+ for His Goat’s Milk Cheeses
Paul Trubey
Business: Beltane Farm
Founded: Cheese production began in 1999, Beltane Farm was
formed in 2002.
Success: Trubey’s cheeses have won awards and are popular
on the farmer’s market circuit.
Paul Trubey always wanted to raise goats. Trained as a social
worker, he finally got his wish in 1994. After a move to Lebanon, Connecticut, Trubey decided that he needed a break
from working hospice. He took a job teaching Latin for a local
school, thinking that he would be able to save some money
and move to Massachusetts with his partner so they could
start a farm. Fate had other plans for Trubey, however. Dorothy Joba, a co-worker, had goats on the farm she had run
with her partner for more than a decade, Highwater Farm. To
indulge his desire to work with goats, Trubey began working
for Joba on nights and weekends. With Joba’s permission,
he began making cheese from the goat milk produced there,
experimenting with artisanal recipes.
After a while, Joba and Trubey came to the conclusion
that he should pursue cheese-making as a profession. The
farm was licensed for cheese production in 1999, forming
Highwater Dairy LLC. Trubey, who had little business experience, had to learn the ins and outs of finance and accounting
in order to record costs and revenues, as well as detail profits
for tax purposes. Trubey had to learn on the job because soon
after
W establishing the dairy, he started selling at the region’s
farmer’s markets and to retail stores and restaurants. In 2000,
I
Trubey’s
Chevre won a blue ribbon in the American Cheese
Society’s
national competition. In 2002, Trubey purchased the
L
herd from Joba and moved them to Beltane Farm in Lebanon,
S
Connecticut.
Although Trubey is back to part-time hospice
work, his business still brings in a profit and his cheeses
O
remain a farmer’s market favorite; people can also visit the
farm
N to make purchases.10
,
accountants divide profits into individual sections such as operating income and
earnings before interest and taxes. Starbucks, for example, lists earnings before
J earnings per share of outstanding stock (see
income taxes, net earnings, and
Table 14.4). Like most companies,
A Starbucks presents not only the current year’s
results but also the previous two years’ income statements to permit comparison of
performance from one period toManother.
I
Temporary Nature of the Income
Statement Accounts. Companies record
their operational activities in theErevenue and expense accounts during an accounting period. Gross profit, earnings before interest and taxes, and net income are the
results of calculations made from the revenues and expenses accounts; they are not
5 accounting period, the dollar amounts in all the
actual accounts. At the end of each
revenue and expense accounts 0
are moved into an account called “Retained Earnings,” one of the owners’ equity accounts. Revenues increase owners’ equity, while
5 change in the owners’ equity account is exactly
expenses decrease it. The resulting
equal to the net income. This shifting
1 of dollar values from the revenue and expense
accounts allows the firm to begin the next accounting period with zero balances in
those accounts. Zeroing out theB
balances enables a company to count how much it
has sold and how many expenses
Uhave been incurred during a period of time. The
basic accounting equation (Assets ⫽ Liabilities ⫹ Owners’ equity) will not balance
until the revenue and expense account balances have been moved or “closed out” to
the owners’ equity account.
One final note about income statements: You may remember from Chapter 5 that
corporations may choose to make cash payments called dividends to shareholders
out of their net earnings. When a corporation elects to pay dividends, it decreases the
cash account (in the assets category of the balance sheet) as well as a capital account
(in the owners’ equity category of the balance sheet). During any period of time, the
owners’ equity account may change because of the sale of stock (or contributions/
withdrawals by owners), the net income or loss, or from the dividends paid.
438
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Accounting and Financial Statements
439
The Balance Sheet
The second basic financial statement is the balance sheet, which presents a “snapshot” of an organization’s financial position at a given moment. As such, the balance
sheet indicates what the organization owns or controls and the various sources of
the funds used to pay for these assets, such as bank debt or owners’ equity.
The balance sheet takes its name from its reliance on the accounting equation:
Assets must equal liabilities plus owners’ equity. Table 14.5 provides a sample balance sheet with line-by-line explanations. Unlike the income statement, the balance sheet does not represent the result of transactions completed over a specified
accounting period. Instead, the balance sheet is, by definition, an accumulation of
all financial transactions conducted by an organization since its founding. Following long-established traditions, items on the balance sheet are listed on the basis of
W than their present values.
their original cost less accumulated depreciation, rather
Balance sheets are often presented in two different
I formats. The traditional balance sheet format placed the organization’s assets on the left side and its liabilities
L
and owners’ equity on the right. More recently, a vertical format, with assets on top
balance sheet
a “snapshot” of an
organization’s
financial position
at a given moment
S
O
TABLE 14.5 Sample Balance Sheet
N
The following exhibit presents a balance sheet in word form with each item defined or explained.
,
Typical Company December 31
Assets
This is the major category for all physical, monetary, or intangible goods that have some
dollar value.
J
Current assets
Assets that are either cash or are expected to be turned into cash within the next 12 months.
Cash
Marketable securities
Accounts receivable
Inventory
A
M
Short-term investments in securities
that can be converted to cash quickly (liquid assets).
Cash due from customers inI payment for goods received. These arise from sales made
on credit.
E
Finished goods ready for sale, goods in the process of being finished, or raw materials
Cash or checking accounts.
used in the production of goods.
Prepaid expense
Total current assets
Fixed assets
Investments
Gross property, plant,
and equipment
Less: Accumulated
depreciation
A future expense item that has already been paid, such as insurance premiums or rent.
5
Assets that are long term in0
nature and have a minimum life expectancy that exceeds
one year.
5
Assets held as investments rather than assets owned for the production process. Most
1 ownership interests in other companies.
often the assets include small
Land, buildings, and other fixed
B assets listed at original cost.
U
The accumulated expense deductions applied to all plant and equipment over their life.
The sum of the above accounts.
Land may not be depreciated. The total amount represents in general the decline in value
as equipment gets older and wears out. The maximum amount that can be deducted is set
by the U.S. Federal Tax Code and varies by type of asset.
Net property, plant,
and equipment
Gross property, plant, and equipment minus the accumulated depreciation. This amount
reflects the book value of the fixed assets and not their value if sold.
Other assets
Any other asset that is long term and does not fit into the above categories. It could be
patents or trademarks.
Total assets
The sum of all the asset values.
(continued)
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440
PART 6
TABLE 14.5
Financing the Enterprise
Sample Balance Sheet (Continued)
Liabilities and
Stockholders’ Equity
This is the major category. Liabilities refer to all indebtedness and loans of both a long-term
and short-term nature. Stockholders’ equity refers to all money that has been contributed
to the company over the life of the firm by the owners.
Current liabilities
Short-term debt expected to be paid off within the next 12 months.
Accounts payable
Money owed to suppliers for goods ordered. Firms usually have between 30 and 90 days to
pay this account, depending on industry norms.
Wages payable
Money owned to employees for hours worked or salary. If workers receive checks every
two weeks, the amount owed should be no more than two weeks’ pay.
Taxes payable
Firms are required to pay corporate taxes quarterly. This refers to taxes owed based on
earnings estimates for the quarter.
Notes payable
Short-term loans from banks or other
Wlenders.
Other current liabilities
The other short-term debts that do not fit into the above categories.
Total current liabilities
Long-term liabilities
Long-term debt
Deferred income taxes
Other liabilities
Stockholders’ equity
Common stock
Capital in excess of par
(a.k.a. contributed capital)
I
L off in the next 12 months.
All long-term debt that will not be paid
Loans of more than one year from S
banks, pension funds, insurance companies, or other
lenders. These loans often take the form of bonds, which are securities that may be bought
O
and sold in bond markets.
This is a liability owed to the government
N but not due within one year.
Any other long-term debt that does not fit the above two categories.
,
The sum of the above accounts.
The following categories are the owners’ investment in the company.
The tangible evidence of ownership is a security called common stock. The par value is
stated value and does not indicateJthe company’s worth.
When shares of stock were sold to the owners, they were recorded at the price at the time
Awas $10 per share, the extra $9 per share would show
of the original sale. If the price paid
up in this account at 100,000 shares
Mtimes $9 per share, or $900,000.
Retained earnings
The total amount of earnings the company has made during its life and not paid out to its
I represents the owners’ reinvestment of earnings
stockholders as dividends. This account
into company assets rather than payments of cash dividends. This account does not
E
represent cash.
Total stockholders’
equity
This is the sum of the above equity accounts representing the owner’s total investment in
the company.
Total liabilities and
stockholders’ equity
current assets
assets that are used
or converted into cash
within the course of a
calendar year
accounts receivable
money owed a company
by its clients or
customers who have
promised to pay for the
products at a later date
fer11722_ch14_421-457.indd 440
5
The total short-term and long-term debt of the company plus the owner’s total investment.
This combined amount must equal0
total assets.
5
1
followed by liabilities and owners’ equity, has gained wide acceptance. Starbucks’
balance sheet for 2004 and 2005Bis presented in Table 14.6. In the sections that follow, we’ll briefly describe the basic
U items found on the balance sheet; we’ll take a
closer look at a number of these in Chapter 16.
Assets. All asset accounts are listed in descending order of liquidity—that is, how
quickly each could be turned into cash. Current assets, also called short-term
assets, are those that are used or converted into cash within the course of a calendar
year. Cash is followed by temporary investments, accounts receivable, and inventory, in that order. Accounts receivable refers to money owed the company by
its clients or customers who have promised to pay for the products at a later date.
Accounts receivable usually includes an allowance for bad debts that management
does not expect to collect. The bad-debts adjustment is normally based on historical
9/22/08 2:19:54 PM
Rev. Confirming Pages
CHAPTER 14
TABLE 14.6
Accounting and Financial Statements
441
Consolidated Balance Sheets (in thousands, except share data)
Fiscal Year Ended
Sept 30, 2007
Oct 1, 2006
Assets
Current assets:
Cash and cash equivalents
Short-term investments—available-for-sale securities
Short-term investments—trading securities
$ 281,261
$ 312,606
83,845
87,542
73,588
53,496
Accounts receivable, net
287,925
224,271
Inventories
691,658
636,222
Prepaid expenses and other current assets
148,757
126,874
129,453
88,777
1,696,487
1,529,788
21,022
5,811
Deferred income taxes, net
Total current assets
Long-term investments—available-for-sale securities
Equity and other investments
Property, plant and equipment, net
Other assets
Other intangible assets
Goodwill
Total Assets
W
I
L
S
O
N
,
258,846
219,093
2,890,433
2,287,899
219,422
186,917
42,043
37,955
215,625
161,478
$5,343,878
$4,428,941
$ 710,248
$ 700,000
390,836
340,937
332,331
288,963
74,591
54,868
Liabilities and Shareholders’ Equity
Current liabilities:
Commercial paper and short-term borrowings
Accounts payable
Accrued compensation and related costs
Accrued occupancy costs
Accrued taxes
J
A
M
I
E
92,516
94,010
Other accrued expenses
257,369
224,154
Deferred revenue
296,900
231,926
5
0
Total current liabilities
Long-term debt
5
Other long-term liabilities
1
Total liabilities
B
Shareholders’ equity:
U shares;
Common stock ($0.001 par value)—authorized, 1,200,000,000
Current portion of long-term debt
issued and outstanding, 738,285,285 and 756,602,701 shares, respectively,
(includes 3,420,448 common stock units in both periods)
Other additional paid-in-capital
Retained earnings
Accumulated other comprehensive income
Total shareholders’ equity
Total Liabilities and Shareholders’ Equity
775
762
2,155,566
1,935,620
550,121
1,958
354,074
262,857
3,059,761
2,200,435
738
756
39,393
39,393
2,189,366
2,151,084
54,620
37,273
2,284,117
2,228,506
$5,343,878
$4,428,941
Source: media.corporate-ir.net/media_files/irol/99/99518/2007AR (accessed September 18, 2008).
fer11722_ch14_421-457.indd 441
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PART 6
Financing the Enterprise
collections experience and is deducted from the accounts receivable balance to present a more realistic view of the payments likely to be received in the future, called
net receivables. Inventory may be held in the form of raw materials, work-in-progress, or finished goods ready for delivery.
Long-term, or fixed assets represent a commitment of organizational funds of
at least one year. Items classified as fixed include long-term investments, plant and
equipment, and intangible assets, such as corporate “goodwill,” or reputation, as
well as patents and trademarks.
current liabilities
a firm’s financial
obligations to
short-term creditors,
which must be repaid
within one year
accounts payable
the amount a company
owes to suppliers for
goods and services
purchased with credit
accrued expenses
is an account
representing all unpaid
financial obligations
incurred by the
organization
Liabilities. As seen in the accounting equation, total assets must be financed either
through borrowing (liabilities) or through owner investments (owners’ equity).
Current liabilities include a firm’s financial obligations to short-term creditors,
which must be repaid within one
Wyear, while long-term liabilities have longer repayment terms. Accounts payable represents amounts owed to suppliers for goods
I For example, if you buy gas with a BP credit
and services purchased with credit.
card, the purchase represents an
Laccount payable for you (and an account receivable for BP). Other liabilities include wages earned by employees but not yet paid
S Occasionally, these accounts are consolidated
and taxes owed to the government.
into an accrued expenses account,
O representing all unpaid financial obligations
incurred by the organization.
N
Owners’ Equity. Owners’ equity includes the owners’ contributions to the orga, by the organization and retained to finance connization along with income earned
tinued growth and development. If the organization were to sell off all of its assets
and pay off all of its liabilities, any remaining funds would belong to the owners.
J as owners’ equity on a balance sheet may differ
Not surprisingly, the accounts listed
dramatically from company to company.
As mentioned in Chapter 5, corporations
A
sell stock to investors, who then become the owners of the firm. Many corporations
M
issue two, three, or even more different classes of common and preferred stock, each
I and/or voting rights. Because each type of stock
with different dividend payments
issued represents a different claim on the organization, each must be represented by
E
a separate owners’ equity account, called contributed capital.
The Statement of Cash Flows
statement of cash flows
explains how the
company’s cash
changed from the
beginning of the
accounting period to
the end
fer11722_ch14_421-457.indd 442
5
The third primary financial statement is called the statement of cash flows,
which explains how the company’s
0 cash changed from the beginning of the accounting period to the end. Cash, of course, is an asset shown on the balance sheet, which
5
provides a snapshot of the firm’s financial position at one point in time. However,
1 of financial statements want more information
many investors and other users
about the cash flowing into and
Bout of the firm than is provided on the balance
sheet in order to better understand the company’s financial health. The statement
U from one year’s balance sheet and compares it
of cash flows takes the cash balance
with the next while providing detail about how the firm used the cash. Table 14.7
presents Starbucks’ statement of cash flows.
The change in cash is explained through details in three categories: cash from
(used for) operating activities, cash from (used for) investing activities, and cash
from (used for) financing activities. Cash from operating activities is calculated by
combining the changes in the revenue accounts, expense accounts, current asset
accounts, and current liability accounts. This category of cash flows includes all the
accounts on the balance sheet that relate to computing revenues and expenses for
the accounting period. If this amount is a positive number, as it is for Starbucks,
9/22/08 2:19:56 PM
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Accounting and Financial Statements
443
then the business is making extra cash that it can use to invest in increased longterm capacity or to pay off debts such as loans or bonds. A negative number may
indicate a business that is in a declining position with regards to operations. Negative cash flow is not always a bad thing, however. It may indicate that a business is
growing, with a very negative cash flow indicating rapid growth.
Cash from investing activities is calculated from changes in the long-term or fixed
asset accounts. If this amount is negative, as is the case with Starbucks, the company
is purchasing long-term assets for future growth. A positive figure indicates a business
that is selling off existing long-term assets and reducing its capacity for the future.
TABLE 14.7
Starbucks Consolidated Statements of Cash
WFlows (in thousands)
Fiscal Year Ended
I
L
Net earnings
S
Adjustments to reconcile net earnings to net cash provided
by operating activities:
O
Cumulative effect of accounting change for FIN 47, net of taxes
N
Depreciation and amortization
,
Provision for impairments and asset disposals
Sept 30, 2007
Oct 1, 2006
Oct 2, 2005
Operating Activities:
$ 672,638
$ 564,259
$ 494,370
—
17,214
—
491,238
412,625
367,207
26,032
19,622
19,464
Deferred income taxes, net
(37,326)
(84,324)
(31,253)
Equity in income of investees
(65,743)
(60,570)
(49,537)
65,927
49,238
30,919
103,865
105,664
—
7,705
1,318
109,978
(93,055)
(117,368)
—
653
2,013
10,097
(48,576)
(85,527)
(121,618)
36,068
104,966
9,717
38,628
54,424
22,711
86,371
132,725
14,435
63,233
56,547
53,276
J
A
Stock-based compensation
Tax benefit from exercise of stock options
M
Excess tax benefit from exercise of stock options
I
Net amortization of premium on securities
E
Cash provided/(used) by changes in operating assets and liabilities:
Distributions of income from equity investees
Inventories
Accounts payable
Accrued compensation and related costs
Accrued taxes
Deferred revenue
Other operating assets and liabilities
Net cash provided by operating activities
Investing Activities:
Purchase of available-for-sale securities
5
0
5
1
B
U
Maturity of available-for-sale securities
(16,437)
(41,193)
(6,851)
1,331,221
1,131,633
922,915
(237,422)
(639,192)
(643,488)
178,167
269,134
469,554
Sale of available-for-sale securities
47,497
431,181
626,113
Acquisitions, net of cash acquired
(53,293)
(91,734)
(21,583)
Net purchases of equity, other investments and other assets
Net additions to property, plant and equipment
Net cash used by investing activities
(56,552)
(39,199)
(7,915)
(1,080,348)
(771,230)
(643,296)
(1,201,951)
(841,040)
(220,615)
(continued)
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PART 6
TABLE 14.7
Financing the Enterprise
Starbucks Consolidated Statements of Cash Flows (in thousands) (Continued)
Financing Activities:
Repayments of commercial paper
(16,600,841)
—
—
Proceeds from issuance of commercial paper
17,311,089
—
—
Repayments of short-term borrowings
(1,470,000)
(993,093)
—
Proceeds from short-term borrowings
770,000
1,416,093
277,000
Proceeds from issuance of common stock
176,937
159,249
163,555
93,055
117,368
—
(784)
(898)
(735)
Excess tax benefit from exercise of stock options
Principal payments on long-term debt
Proceeds from issuance of long-term debt
548,960
—
—
Repurchase of common stock
(996,798)
(854,045)
(1,113,647)
W
Other
I
Net cash used by financing activities
L
Effect of exchange rate changes on cash and cash equivalents
S
Net increase/(decrease) in cash and cash equivalents
O
Cash and Cash Equivalents:
Beginning of period
N
End of the period
,
(3,505)
—
—
(171,887)
(155,326)
(673,827)
11,272
3,530
283
(31,345)
138,797
28,756
312,606
173,809
145,053
$ 281,261
$ 312,606
$ 173,809
Supplemental Disclosure of Cash Flow Information:
Cash paid during the period for:
$ 35,294
$ 10,576
$ 1,060
J
Income taxes
$ 342,223
$ 274,134
$ 227,812
A
Source: media.corporate-ir.net/media_files/irol/99/99518/2007AR (accessed September 18, 2008).
M
I
Finally, cash from financing activities
is calculated from changes in the long-term
E
Interest, net of capitalized interest
liability accounts and the contributed capital accounts in owners’ equity. If this
amount is negative, the company is likely paying off long-term debt or returning
contributed capital to investors.5As in the case of Starbucks, if this amount is positive, the company is either borrowing more money or raising money from investors
by selling more shares of stock. 0
5
Ratio Analysis: Analyzing
Financial
1
Statements
B
The income statement shows aUcompany’s profit or loss, while the balance sheet
ratio analysis
calculations that
measure an
organization’s
financial health
fer11722_ch14_421-457.indd 444
itemizes the value of its assets, liabilities, and owners’ equity. Together, the two statements provide the means to answer two critical questions: (1) How much did the
firm make or lose? and (2) How much is the firm presently worth based on historical values found on the balance sheet? Ratio analysis, calculations that measure
an organization’s financial health, brings the complex information from the income
statement and balance sheet into sharper focus so that managers, lenders, owners,
and other interested parties can measure and compare the organization’s productivity, profitability, and financing mix with other similar entities.
9/23/08 11:44:14 AM
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CHAPTER 14
Accounting and Financial Statements
445
You can look on Web sites
like Yahoo! Finance under a
company’s “key statistics”
link to find many of its
financial ratios, such as its
return on assets, return on
equity, and current ratio.
Other ratios require a closer
look at a company’s actual
financial statements.
W
I
L
S by another, with the result
As you know, a ratio is simply one number divided
showing the relationship between the two numbers. Financial
ratios are used to weigh
O
and evaluate a firm’s performance. An absolute value such as earnings of $70,000 or
N as much useful information
accounts receivable of $200,000 almost never provides
as a well-constructed ratio. Whether those numbers
, are good or bad depends on
their relation to other numbers. If a company earned $70,000 on $700,000 in sales
(a 10 percent return), such an earnings level might be quite satisfactory. The president of a company earning this same $70,000 on sales
J of $7 million (a 1 percent
return), however, should probably start looking for another job!
Ratios by themselves are not very useful. It is theArelationship of the calculated
ratios to both prior organizational performance and
Mthe performance of the organization’s “peers,” as well as its stated goals, that really matters. Remember, while the
I
profitability, asset utilization, liquidity, debt ratios, and per share data we’ll look at
here can be very useful, you will never see the forest E
by looking only at the trees.
Profitability Ratios
5 income or net income an
Profitability ratios measure how much operating
organization is able to generate relative to its assets,0owners’ equity, and sales. The
numerator (top number) used in these examples is always the net income after taxes.
Common profitability ratios include profit margin, 5
return on assets, and return on
equity. The following examples are based on the 2007
1 income statement and balance sheet for Starbucks, as shown in Tables 14.4 and 14.6. Except where specified,
B
all data are expressed in millions of dollars.
The profit margin, computed by dividing net income
U by sales, shows the overall percentage profits earned by the company. It is based solely upon data obtained
from the income statement. The higher the profit margin, the better the cost controls within the company and the higher the return on every dollar of revenue. Starbucks’ profit margin is calculated as follows:
Profit margin ⫽
$672,638
$9,411,487
profitability ratios
ratios that measure the
amount of operating
income or net income
an organization is able
to generate relative
to its assets, owners’
equity, and sales
profit margin
net income divided by
sales
⫽ 7..15%
Thus, for every $1 in sales, Starbucks generated profits of just over 7 cents.
fer11722_ch14_421-457.indd 445
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Consider Ethics and Social Responsibility
Holding Companies Responsible: The Public Company
Accounting Oversight Board
The Financial Accounting Standards Board (FASB) has been
establishing standards for financial accounting and reporting
in the private sector since 1973. Its main mission is to provide
guidance for the utilization of responsible accounting methods, reporting, and policies to protect investors, lenders, and
the public. By the turn of the 21st century, however, it was
clear that the FASB did not provide strong enough regulatory measures. In response to public outrage surrounding
corporate accounting scandals at Enron, WorldCom, and
many other firms, in which many thousands of investors and
employees lost much of their savings, Congress passed the
Sarbanes-Oxley Act (SOX) in 2002 to restore stakeholder confidence in business financial reporting. Among its many provisions, the Sarbanes-Oxley Act established oversight of public
corporate governance and financial reporting obligations and
redesigned accountability and ethics standards for corporate
officers, auditors, and analysts. Before SOX established an
oversight mechanism for accounting, it had, to some extent,
been self-regulatory.
The Sarbanes-Oxley Act established the Public Company
Accounting Oversight Board (PCAOB), which oversees the
audit of public companies in order to protect the interests of
investors and further the public interest in the preparation
of informative, accurate, and independent audit reports for
companies. The duties of the PCAOB include registration of
public accounting firms; establishment of standards for auditing, quality control, ethics, independence, and other issues
relating to preparation of audit reports; inspection of accounting firms; investigations, disciplinary actions, and sanctions;
and enforcement of compliance through the use of accounting rules of the board, professional standards and securities
laws for the preparation and issuance of audit reports, and
obligations and liabilities of accountants. The accounting
oversight board established by SOX placed considerable government control over the accounting industry and the public
firms they serve.
The oversight board files reports with the Securities and
Exchange Commission (SEC) on an annual basis that include
any new established rules and any final disciplinary rulings.
The SEC itself is responsible for protecting investors, maintaining fair and efficient markets, and facilitating capital creation.
return on assets
net income divided by
assets
While the FASB has been involved in accounting standards for
decades, it has butted heads with the SEC from time to time,
particularly because the SEC has to approve the FASB’s budget. Essentially, the SEC has a hand in every pot both in the
world of private business and in government.
Since the 2002 introduction of Sarbanes-Oxley, much
adjustment has occurred. Although accounting seems to be
straightforward, it is not; and the standards applied to company accounting undergo nearly constant revision. Also
under
W reconsideration are the organizations in charge of creating these standards. Accounting is critical in that it is used
toI create the public’s perception of a company. To this end,
there
L is a constant battle raging over whether or not accounting should be considered public or private policy. In the heat
ofSthe battle are the SEC, the FASB, the PCAOB, the American Institute of Certified Public Accountants (AICPA), public
O
accounting firms, and the business lobby. The reason for
the
Nbattle goes back to the Sarbanes-Oxley Act, which was
created, as previously mentioned, to clarify and delineate
, positions held by all those involved in setting the rules of
the
accounting. After five years, the SEC has come out on top and
is beginning to seriously exert its strength.
JThe powerful stance of the current SEC makes businesses
nervous
A for a number of reasons. First, politicians control the
SEC, a situation that can create a sense of imbalance. SecM the SEC’s drive toward one set of standards throughout
ond,
the global world of business may simplify things, but at the
I
same time it may make necessary an overhaul of all accounting
E practices. Some worry that, although the restrictions
created by Sarbanes-Oxley are objectionable to many firms,
these may pale in comparison to what the SEC has in mind for
11
the
5 future.
0
Discussion
Questions
1. Why do the SEC and the FASB disagree on some account5ing issues?
2.1Why was the Sarbanes-Oxley Act created?
3. Opponents of increased accounting and regulatory overBsight have cited increased costs of complying with SOX
Uas a reason it should be repealed—do you think this is a
valid complaint?
Return on assets, net income divided by assets, shows how much income the
firm produces for every dollar invested in assets. A company with a low return on
assets is probably not using its assets very productively—a key managerial failing.
For its construction, the return on assets calculation requires data from both the
income statement and the balance sheet.
446
fer11722_ch14_421-457.indd 446
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CHAPTER 14
Return on assets ⫽
Accounting and Financial Statements
$672,638
$5,343,878
447
⫽ 12.59%
In the case of Starbucks, every $1 of assets generated a return of around 12.6 percent, or profits of around 12.6 cents per dollar.
Stockholders are always concerned with how much money they will make on
their investment, and they frequently use the return on equity ratio as one of their
key performance yardsticks. Return on equity (also called return on investment
[ROI]), calculated by dividing net income by owners’ equity, shows how much
income is generated by each $1 the owners have invested in the firm. Obviously, a
low return on equity means low stockholder returns and may indicate a need for
immediate managerial attention. Because some assets may have been financed with
debt not contributed by the owners, the value of theW
owners’ equity is usually considerably lower than the total value of the firm’s assets.
I Starbucks’ return on equity
is calculated as follows:
return on equity
net income divided by
owner’s equity; also
called return on
investment (ROI)
L
Return on equity ⫽
$672,638
S ⫽ 29.45%
$2,284,117
O
For every dollar invested by Starbucks stockholders, the company earned a 29.45
N reason the amount is higher
percent return, or 29.45 cents per dollar invested. The
than the return on assets is that owners’ equity only, accounts for about 43 percent
of Starbucks’ assets, while the other 57 percent is financed by debt.
Asset Utilization Ratios
J
Asset utilization ratios measure how well a firm uses its assets to generate each
A more productively will have
$1 of sales. Obviously, companies using their assets
higher returns on assets than their less efficient competitors.
Similarly, managers can
M
use asset utilization ratios to pinpoint areas of inefficiency in their operations. These
I
ratios (receivables turnover, inventory turnover, and total asset turnover) relate balE statement.
ance sheet assets to sales, which are found on the income
The receivables turnover, sales divided by accounts receivable, indicates how
many times a firm collects its accounts receivable in one year. It also demonstrates how
5 sales. Obviously, no payments
quickly a firm is able to collect payments on its credit
means no profits. Starbucks collected its receivables 0
32.7 times per year. The reason
the number is so high is that most of Starbucks’ sales are for cash and not credit.
asset utilization ratios
ratios that measure
how well a firm uses
its assets to generate
each $1 of sales
receivables turnover
sales divided by
accounts receivable
5
Receivables turnover ⫽
$9,411,497
1
$2877,925
⫽ 32.69 ⫻
B
Inventory turnover, sales divided by total inventory, indicates how many times
U of a year. A high inventory
a firm sells and replaces its inventory over the course
inventory turnover
sales divided by total
inventory
turnover ratio may indicate great efficiency but may also suggest the possibility of
lost sales due to insufficient stock levels. Starbucks’ inventory turnover indicates
that it replaced its 13.6 times lost year, or more than once a month.
Inventory turnover ⫽
$9,411,497
$691,6658
⫽ 13.61 ⫻
Total asset turnover, sales divided by total assets, measures how well an organization uses all of its assets in creating sales. It indicates whether a company is
fer11722_ch14_421-457.indd 447
total asset turnover
sales divided by total
assets
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PART 6
Financing the Enterprise
using its assets productively. Starbucks generated $1.76 in sales for every $1 in total
corporate assets.
Total asset turnover ⫽
$9,411,497
$5,3443,878
⫽ 1.76 ⫻
Liquidity Ratios
liquidity ratios
ratios that measure
the speed with which
a company can turn
its assets into cash to
meet short-term debt
current ratio
current assets divided
by current liabilities
quick ratio (acid test)
a stringent measure of
liquidity that eliminates
inventory
Liquidity ratios compare current (short-term) assets to current liabilities to indicate the speed with which a company can turn its assets into cash to meet debts as
they fall due. High liquidity ratios may satisfy a creditor’s need for safety, but ratios
that are too high may indicate that the organization is not using its current assets
efficiently. Liquidity ratios are W
generally best examined in conjunction with asset
utilization ratios because high turnover ratios imply that cash is flowing through an
I
organization very quickly—a situation
that dramatically reduces the need for the
type of reserves measured by liquidity
ratios.
L
The current ratio is calculated by dividing current assets by current liabilities.
S that for every $1 of current liabilities, the firm
Starbucks’s current ratio indicates
had $0.79 of current assets on hand.
O This number may appear troublesome, and it
should be a ratio on which the company keeps a close watch. Overall liquidity has
N and 2007. Additionally, accounts receivable has
decreased somewhat between 2006
increased over the same time period.
, This shows that Starbucks’ asset turnover rate
is beginning to slow in addition to decreasing liquidity—all coming at a time of
sales and expansion slowdowns for Starbucks.
J
$1,696,487
Current ratio A⫽
⫽ 0.79 ⫻
$2,155,566
M
The quick ratio (also known as the acid test) is a far more stringent measure
I inventory, the least liquid current asset. It meaof liquidity because it eliminates
sures how well an organizationE
can meet its current obligations without resorting
to the sale of its inventory. In 2007, Starbucks had just 47 cents invested in current assets (after subtracting inventory) for every $1 of current liabilities, a slight
increase over 2006.
5
Quick ratio 0
⫽
debt utilization ratios
ratios that measure
how much debt an
organization is using
relative to other
sources of capital,
such as owners’ equity
fer11722_ch14_421-457.indd 448
$1,004,829
$2,155,566
⫽ 0..47 ⫻
5
1
Debt Utilization Ratios
B information about how much debt an organizaDebt utilization ratios provide
tion is using relative to other sources
U of capital, such as owners’ equity. Because the
use of debt carries an interest charge that must be paid regularly regardless of profitability, debt financing is much riskier than equity. Unforeseen negative events such
as recessions affect heavily indebted firms to a far greater extent than those financed
exclusively with owners’ equity. Because of this and other factors, the managers of
most firms tend to keep debt-to-asset levels below 50 percent. However, firms in
very stable and/or regulated industries, such as electric utilities, often are able to
carry debt ratios well in excess of 50 percent with no ill effects.
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Accounting and Financial Statements
The debt to total assets ratio indicates how much of the firm is financed by
debt and how much by owners’ equity. To find the value of Starbucks’ total debt, you
must add current liabilities to long-term debt and other liabilities.
$3,059,7617
$5,3443,878
Debt to total assets ⫽
⫽ 57.26%
Thus, for every $1 of Starbucks’ total assets, nearly 57.3 percent is financed with
debt. The remaining 42.7 percent is provided by owners’ equity.
The times interest earned ratio, operating income divided by interest
expense, is a measure of the safety margin a company has with respect to the interest
payments it must make to its creditors. A low times interest earned ratio indicates
that even a small decrease in earnings may lead the company into financial straits.
Wexpense, it would appear that
Since Starbucks has more interest income than interest
their times interest earned ratio is not able to be calculated
I by using the income statement. However, in the statement of cash flows in Table 14-7 on the second line from
L
the bottom, we can see that Starbucks, just under $35.3 million in interest expense,
S before interest and taxes.
an amount that was covered nearly 29.9 times by income
A lender would probably not have to worry about receiving
interest payments.
O
Times interest earned ⫽
$1,053,945
N
$35,, 294
449
debt to total assets ratio
a ratio indicating how
much of the firm is
financed by debt and
how much by owners’
equity
times interest earned
ratio
operating income
divided by interest
expense
⫽ 29.86 ⫻
,
Per Share Data
Investors may use per share data to compare theJperformance of one company
with another on an equal, or per share, basis. Generally, the more shares of stock a
company issues, the less income is available for eachA
share.
Earnings per share is calculated by dividing net
Mincome or profit by the number of shares of stock outstanding. This ratio is important because yearly changes
I
in earnings per share, in combination with other economywide
factors, determine
a company’s overall stock price. When earnings goE
up, so does a company’s stock
price—and so does the wealth of its stockholders.
Diluted earnings per share ⫽
$672,638
5
$7770,091
⫽ 0.87 (2007)
⫽
$564,2595
$792, 556
⫽ 0.71 (2006)
0
per share data
data used by investors
to compare the
performance of one
company with another
on an equal, per
share basis
earnings per share
net income or profit
divided by the number
of stock shares
outstanding
1
We can see from the income statement that Starbucks’ basic earnings per share
B
increased from $0.74 in 2006 to $0.90 in 2007. Notice that Starbucks lists diluted
U and $0.87 for 2007. You can
earnings per share, calculated here, of $0.71 for 2006
see from the income statement that diluted earnings per share include more shares
than the basic calculation; this is because diluted shares include potential shares that
could be issued due to the exercise of stock options or the conversion of certain
types of debt into common stock. Investors generally pay more attention to diluted
earnings per share than basic earnings per share.
Dividends per share are paid by the corporation to the stockholders for each
share owned. The payment is made from earnings after taxes by the corporation but
fer11722_ch14_421-457.indd 449
dividends per share
the actual cash
received for each share
owned
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PART 6
Financing the Enterprise
is taxable income to the stockholder. Thus, dividends result in double taxation: The
corporation pays tax once on its earnings, and the stockholder pays tax a second
time on his or her dividend income. Starbucks has never paid a dividend, so the
calculation of dividends per share does not apply in this case.
Dividends per share ⫽
$0
$770,091
⫽ 0
Industry Analysis
We have used McDonald’s as a comparison to Starbucks because there are no real
national and international coffee houses that compete with Starbucks on the same
scale. While McDonald’s is almost four times larger than Starbucks in terms of sales,
W
they both have a national and international
presence and to some extent compete
for the consumer’s dollars. Table
14.8
shows
that while McDonald’s earns more
I
profit per dollar of sales, Starbucks earns more dollars per dollar of invested assets.
L shop is much less expensive to build and operate
This is because a Starbucks coffee
than a McDonald’s. Both companies
S have very little accounts receivable relative to
the size of their sales. McDonald’s pushes off much of its inventory holding costs
on its suppliers and so has muchOless inventory per sales dollar compared with Starbucks. Because McDonald’s hasN
very little inventory, its current ratio is almost the
same, and its quick ratio is much higher than Starbucks. This is of little consequence
,
to the financial analyst because both companies have high times interest earned
ratios, with Starbucks significantly higher than McDonald’s. Starbucks earns less
per share than McDonald’s, butJMcDonald’s pays a dividend and Starbucks does
not. In summary, both companies are in good financial health, and it is hard to
A
say which company is better managed.
One thing for sure, if Starbucks could earn
the same profit margin as McDonald’s,
they
would improve their other profitability
M
ratios dramatically.
I
E
TABLE 14.8
Industry Analysis
Starbucks
Profit margin
Return on assets
Return on equity
Receivable turnover
Inventory turnover
Total asset turnover
Current ratio
Quick ratio
Debt to total assets
Times interest earned
5
0
5
1
B
U
McDonald’s
7.15%
10.51%
12.59%
8.15%
29.45%
15.67%
32.69⫻
21.64⫻
13.61⫻
182.30⫻
1.76⫻
0.78⫻
0.79⫻
0.80⫻
0.47⫻
0.77⫻
57.26%
48.01%
29.86⫻
9.46⫻
Earnings per share
$ 0.87
$ 1.98
Dividends per share
$ 0.00
$ 1.50
By tracking and analyzing the financial data of 18 million-plus U.S. businesses, BizMiner.com is able to deliver industry
analysis information to its online subscribers.
fer11722_ch14_421-457.indd 450
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CHAPTER 14
Accounting and Financial Statements
451
So You Want to Be an Accountant
Do you like numbers and finances? Are you detail oriented, a perfectionist, and highly accountable for your
decisions? If so, accounting may be a good field for you.
If you are interested in accounting, there are always job
opportunities available no matter the state of the economy.
Accounting is one of the most secure job options in business. Of course, becoming an accountant is not easy. You
will need at least a bachelor’s degree in accounting to
get a job, and many positions require additional training.
Many states demand coursework beyond the 120 to 150W
credit hours collegiate programs require for an accounting degree. If you are really serious about getting into theI
accounting field, you will probably want to consider get-L
ting your master’s in accounting and taking the CPA exam.
The field of accounting can be complicated, and the extraS
training provided through a master’s in accounting pro-O
gram will prove invaluable when you go out looking for
N
a good job. Accounting is a volatile discipline affected by
changes in legislative initiatives.
,
With corporate accounting policies changing constantly and becoming more complex, accountants are
needed to help keep a business running smoothly andJ
within the bounds of the law. In fact, the number of jobs inA
the accounting and auditing field are expected to increase
18 percent between 2006 and 2016, with more than 1.5M
million jobs in the United States alone by 2016. Jobs inI
accounting tend to pay quite well, with the national average salary standing at just over $57,000 annually. If you
go on to get your master’s degree in accounting, expect
to see an even higher starting wage. In 2006, accountants
with a bachelor’s degree received an average opening
offer of $47,618, while employees with master’s degrees
were offered $49,277 starting. Of course, your earnings
could be higher or lower than these averages, depending on where you work, your level of experience, the firm,
and your particular position.
Accountants are needed in the public and the private
sectors, in large and small firms, in for-profit and not-forprofit organizations. Accountants in firms are generally
in charge of preparing and filing tax forms and financial
reports. Public-sector accountants are responsible for
checking the veracity of corporate and personal records
in order to prepare tax filings. Basically, any organization
that has to deal with money and/or taxes in some way or
another will be in need of an accountant, either for inhouse service or occasional contract work. Requirements
for audits under the Sarbanes Oxley Act and rules from the
Public Company Accounting Oversight Board are creating
more jobs and increased responsibility to maintain internal
controls and accounting ethics. The fact that accounting
rules and tax filings tend to be complex virtually assures
that the demand for accountants will never decrease.12
E
Review Your Understanding 5
Define accounting, and describe the different uses of
0
accounting information.
Accounting is the language businesses and other orga-5
nizations use to record, measure, and interpret financial
1
transactions. Financial statements are used internally
to judge and control an organization’s performance andB
to plan and direct its future activities and measure goal
attainment. External organizations such as lenders, gov-U
ernments, customers, suppliers, and the Internal Revenue
Service are major consumers of the information generated
by the accounting process.
Demonstrate the accounting process.
Assets are an organization’s economic resources; liabilities, debts the organization owes to others; owners’ equity,
and the difference between the value of an organization’s
assets and liabilities. This principle can be expressed as
fer11722_ch14_421-457.indd 451
the accounting equation: Assets ⫽ Liabilities ⫹ Owners’
equity. The double-entry bookkeeping system is a system of recording and classifying business transactions
in accounts that maintain the balance of the accounting
equation. The accounting cycle involves examining source
documents, recording transactions in a journal, posting
transactions, and preparing financial statements on a continuous basis throughout the life of the organization.
Decipher the various components of an income
statement in order to evaluate a firm’s “bottom line.”
The income statement indicates a company’s profitability over a specific period of time. It shows the “bottom
line,” the total profit (or loss) after all expenses (the costs
incurred in the day-to-day operations of the organization)
have been deducted from revenue (the total amount of
money received from the sale of goods or services and
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Confirming Pages
452
PART 6
Financing the Enterprise
other business activities). The cash flow statement details
how much cash is moving through the firm and thus adds
insight to a firm’s “bottom line.”
Interpret a company’s balance sheet to determine
its current financial position.
The balance sheet, which summarizes the firm’s assets,
liabilities, and owners’ equity since its inception, portrays
its financial position as of a particular point in time. Major
classifications included in the balance sheet are current
assets (assets that can be converted to cash within one
calendar year), fixed assets (assets of greater than one
year’s duration), current liabilities (bills owed by the organization within one calendar year), long-term liabilities
(bills due more than one year hence), and owners’ equity
(the net value of the owners’ investment).
Analyze financial statements, using ratio analysis,
to evaluate a company’s performance.
Ratio analysis is a series of calculations that brings the
complex information from the income statement and balance sheet into sharper focus so that managers, lenders,
Revisit the World of Business
1.
It is difficult to encourage competition in basic
service industries, like phone service. What might
Calderón suggest to Slim that could allow for
increased competition?
Learn the Terms
accounting 425
accounting cycle 431
accounting equation 431
accounts payable 442
accounts receivable 440
accrued expenses 442
annual report 429
asset utilization ratios 447
assets 430
balance sheet 439
budget 428
cash flows 428
certified management accountants
(CMAs) 427
cert...
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